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Measures would subsidize financial institutions at expense of taxpayers

The chairman of the Federal Reserve touched on a very important point last week when he said of Senate Banking Committee Chairman Chris Dodd’s (D-Conn.) regulatory reform legislation, “It makes us essentially the too-big-to-fail regulator.”

Ben Bernanke was referring to the fact that under the bill the Fed would be the primary regulator overseeing banks and bank holding companies with assets of more than $50 billion as well as any institution the newly created Financial Stability Oversight Council believes could pose a systemic risk to the financial system. Backstopping these firms will be a $50 billion bailout fund. Should $50 billion not be sufficient, the fund can issue virtually an unlimited amount of debt that “shall be treated as public debt transactions of the United States” (that is, paid for by the American taxpayers). The problem with this approach (beyond the potential taxpayer losses) is that it reinforces the existence of a too-big-to-fail industry.

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The bill put forward by Chairman Dodd, as well as the bill passed by the House late last year, fail on many levels; however, institutionalizing instead of eliminating the too-big-to-fail problem will likely be the most damaging. The ultimate cost of this failure will be shouldered by our capital markets, and our financial system will be split between the haves (those with a taxpayer guaranty) and the have-nots (everyone else).

Those institutions labeled too-big-to-fail will see a significant competitive advantage over smaller firms. In fact, we have already seen evidence of this phenomenon. A recent study by the Center for Economic and Policy Research found that the too-big-to-fail doctrine has translated into a tangible subsidy for the 18 largest bank holding companies worth $34 billion per year and a 78 basis points lower cost of capital when compared to their smaller competitors.

Armed with the competitive advantage, these mammoth financial institutions will dominate the marketplace. This is precisely what happened with the government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, the original too-big-to-fail institutions. Fannie and Freddie wiped out any competition and formed a duopoly over the prime secondary mortgage market because they were perceived to be government-backed. This seal of approval absolved these mortgage giants of any type of market discipline that would have kept in check wholly private firms.

In part, the bifurcation of our financial system started with TARP. While today the bank bailout has developed into a gravy train going to a broad array of institutions, it initiated this idea that the U.S. government stood behind a handful of the largest financial institutions. Instead of attempting to reverse the damage done by TARP and assure the capital markets that no institution will ever be viewed as government backed, the regulatory reform bills compound the problem and guarantee this problem will be with us well into the future.

Another ill effect of creating a too-big-to-fail industry is the inextricable link established between big business and big government. Undoubtedly, favors will be doled out by both sides of this relationship. Again, Fannie and Freddie set a precedent on the subject. They were able to continue their reckless ways because they had enough allies in Congress willing to turn a blind eye to safety and soundness as long as the GSEs met their demands. Getting every American into a home was their goal and the GSEs were their primary vehicle. Through the affordable housing goals put in place in 1992, the GSEs became the largest purchasers of junk mortgages (over $1 trillion worth). This meant that despite the low quality of the loans, millions of Americans now had a mortgage they otherwise could not afford. Believing they should be doing even more to promote affordable housing, their allies in Congress created a fund that literally took a portion of the companies’ profits and sent it to like-minded activist organizations. It should come as no surprise that those at the center of the Fannie and Freddie debacle are the driving force behind the current proposal.

Going forward, similar favors will be offered in exchange for leniency on this new class of too-big-to-fail institutions. Instead of focusing on providing the best possible service to their customers, these banks will focus their efforts on appeasing the federal government and their allies in Congress. Whether it is striving toward another altruistic goal while defying the principles of sound banking, or funneling cash into friendly organizations, the closer big government gets to big business the more likely these favors will become the rule instead of the exception. Political pull will replace market forces and vanquish market discipline.

Despite the rhetoric coming from those behind this approach, this bill will not prevent a future bubble and subsequent bust, but rather, exacerbate it. Instead of going down this path, we need to scale back the government safety net afforded to these banks and send a strong message to our capital markets: no institution is ever too big to fail.